Volatility returned to the equity markets in the first quarter of 2010 with an 8.2% drop in the S&P 500 index from Jan 19 – Feb 8 followed by an 11.2% gain from Feb 8 – Mar 30. A mixed bag of reports on the economic recovery in the US combined with fears of default by the weakest members of the European Monetary Union (EMU) prompted investors to sell equity holdings in January and February. Chief executives continued to sound upbeat about corporate earnings for 2010 and a return to more robust sales growth in the coming quarters. EMU leaders issued statements of support for their member countries and began to outline austerity measures designed to reduce public debt levels in Greece and Portugal over time.

The Industrial, Consumer Discretionary and Financial sectors led the S&P 500 index for the quarter with double-digit percentage gains. The Telecom, Utility and Energy sectors were the worst performers of the index. The total return for the S&P 500 index was 5.4% for the first quarter of 2010.1

Next, we take a closer look at a few of the themes that dominated financial headlines in recent months.

Headline: National Debt Seen Heading for Crisis Level2

This is the latest in a long list or articles that cite a recent study by two economists. The study claims that a 90% debt to GDP ratio is the magic number that sets off a debt crisis. This analysis is detailed in the book by Rogoff and Reinhart, titled This Time is Different where the authors reviewed hundreds of financial crises in 66 countries over 800 years and attempted to draw some conclusions. In the first several pages of the book, the authors preface their findings by saying, “We begin by discussing sovereign default on external debt (i.e., a government default on its own external debt or private sector debts that were publicly guaranteed.).3” In other words, the authors are referring to nations that issue debt in a foreign currency. The United States does not issue debt in a foreign currency, but does have foreign holders of dollar-denominated debt. There is a meaningful difference between those two scenarios. Why then would a journalist reference a study that does not apply to the United States with the before-mentioned headline? She is drawing conclusions about our monetary system based on a misunderstanding of the data. Japan has a debt to GDP ratio of almost 200% and has not experienced a debt crisis. In fact, the Japanese government is currently issuing debt at less than 2% for a ten year note.

A more interesting analysis might look at the rate of change of our national debt to determine if there are other time periods in the history of the United States where public debt was increasing at a double-digit rate (like it is today). It happened most recently from 1982 – 1992. So, what economic crisis occurred in 1993 after the national debt had increased over 250% in the previous 10 years? US GDP grew by 2.9% and the S&P 500 index returned 6.5%.4

A common mistake is to equate the public debt of a sovereign nation (United States, Japan, Australia, Canada, UK) with that of a household, corporation or even an individual state (California comes to mind). As the monopoly issuer of a currency that is legal tender for all debts, publicand private the US Federal Reserve is in the unique position to create money necessary to settle those debts. In fact, they do it every day when Treasury Bills mature. Therefore, the probability of default by the United States is close enough to zero to be a non-issue. What is a very real issue is the deterioration of useful skills by unemployed workers. Any productive utilization of the displaced workforce would have a positive effect on the overall prospects for the economy. That could be in the form of new skills training programs or temporary work contracts. Unfortunately, our elected officials in Washington D.C. can’t seem to figure out how to respond to highly elevated levels of unemployment in a timely manner.

Headline: The Lost Decade of Stock Investing5

The 10 year period that ended December 31, 2009 was not a prosperous decade for the average investor. This has prompted newspaper pundits to declare stock market investing to be “too risky” for the majority of Americans. What these articles fail to discuss is the difference between the average investor and the educated investor. Let’s assume the average investor (Avg) buys a mutual fund that tracks the S&P 500 index and the educated investor (Edu) does his own research and buys individual common stocks. What would the performance be for these two investors over the past decade?

To demonstrate the return dispersion between Avg and Edu, we can simply rewind the clock to December 31, 1999 and run a simulation with a hypothetical $10,000 investment. Avg buys the Vanguard 500 Index Fund (VFINX) and Edu decides to pick 10 stocks from the Dow Jones Industrial Average. Let’s fast forward 10 years and check their December 2009 statement to see how they faired. Avg investor would have about $9,035 of his original $10,000 for a total return of -9.8%. Depending on his stock picking ability, Edu would have anywhere from $7,000 to $17,700 for a total return of -30% for the worst performers of the Dow to a 77% gain for the best performers.6

This is a simple example, but demonstrates the wide variation of investment returns available when selecting individual stocks versus an average return that blends the best and worst returns together. Therefore, the key to an above-average return is to consistently select the best performing stocks over time. This is a difficult task, but not impossible for the educated investor!

At DLK, we remain committed to providing you with the best investment advice and portfolio management available to suit your financial goals. Thank you for continuing to trust us as your investment advisor.